For information purposes only. The views and opinions expressed here are those of the author at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.
We are strongly of the view that the market regime changed in 2020, with the end of the disinflationary era and the re-emergence of inflation as a factor. Disinflation created the anomalous effect that equities and bonds became negatively correlated for an extended period. This should not be the case, all assets are priced off the ‘risk free’ rate – the bond yield. So positive correlation should be the norm.
We are now back in a period of more normal inflation and growth; indeed, inflation remains above most central banks target levels. Despite this, markets are pricing in rate cuts in the near term. Equities have been strong as inflation expectations have come down, alongside stronger bond markets.
Having seen a strong rally, as inflation expectations have reduced near term, it pays to ask what bonds are pricing in. The textbooks would suggest that, for example, US ten year bonds should reflect the markets expectation of nominal economic growth over the coming ten years – the opportunity cost of tying your money up for ten years. Whilst we can argue that point in the context of aggressive intervention and leverage, it provides a framework to get an idea of where they might be headed over the long term.
Current US ten-year yields are 4%. That suggests the market expects 4% per annum nominal GDP growth over the next ten years. The working age population in the US is estimated to be growing at between 1.2% and 1.5%*. Productivity per worker might be expected to grow at something less than 1%**, which suggest the market expects inflation to fall back to close to 2% or less over the coming years.
Markets are pricing a reversion to the post GFC environment. Alternatively, they are pricing a period of economic contraction and/or further disinflation here. Simultaneously, equity markets appear to believe the soft-landing scenario.
We think 2% inflation is implausible for all the reasons we have outlined before. More reasonable would be an expectation of 3% or above, in line with longer term history. In fact, our thesis is a period of relatively high inflation with a series of peaks over the coming years followed by falls. In that case, bond yields could be set for a resumption of their uptrend, particularly if the soft landing materialises, while inflation remains above target. Longer term, we see yields averaging 5% or higher over the decade, potentially with periods where they go significantly higher than that.
That makes bonds a difficult asset class for investors to use as a diversifier for equities. The downside risk coincides with downside risk in equities. Periods of rising inflation will likely coincide with weaker equity markets. In those circumstances bonds will provide no diversification benefit, unless only short dated bonds are held. To diversify inflation, less interest rate sensitive real assets need to be held, such as commodities or gold. Aggressively actively managing asset allocation can deal with this more volatile economic environment. Safer would be to hold a portfolio focused on real assets, with short term bonds as a cash proxy to reduce volatility if necessary.
Premier Miton Macro Thematic Multi Asset Team
*Organization for Economic Co-operation and Development, Working Age Population: Aged 15-64: All Persons for United States [LFWA64TTUSM647S], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/LFWA64TTUSM647S, January 11, 2024
**University of Groningen and University of California, Davis, Total Factor Productivity at Constant National Prices for United States [RTFPNAUSA632NRUG], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/RTFPNAUSA632NRUG, January 11, 2024.